Cash can exist in many forms. We term anything that is not actual cash as proxy cash. Proxy cash shows in the transaction accounting systems and is mixed with accrual type accounts.
To better understand and manage the continuum of cash, we need to select valid proxy cash accounts that reflect as close a proximity to cash as possible.
Next is putting these accounts into a structure with a format that is useful for understanding any business. Typically this will begin with inflows and then be followed by the various categories of outflows.
This design is a new cash flow statement that depicts both the strategic and operational aspect of a business. At the end of this exercise, we have a new cash flow statement.
For management, the Funding Model shows all the sources of cash, as well as all the movements and outflows of cash. For providers of finance, it shows the entire cash picture and quickly highlights leakages and potential problem areas
The Funding Model
We termed this structure the Funding Model, which is shown in the diagram below.
The diagram shows the 14 parent categories in the Funding Model. Within this, we have identified 44 'child' accounts. The model is very comprehensive so as to accommodate all cash-related items, but not all the categories and child accounts apply to all organizations. The model should therefore be customized to suit each business.
The opening bank balance for the first month (or daily or weekly) is inputted. The Funding Model will then calculate the bank balance for future periods. If there is any leakage, it will show in this row. This means that a great amount of detailed data can be analyzed, forecast and used to assist management.
The Funding Model is populated by the business units either from the accounting system or directly into an Excel template that is automatically consolidated by the CFO or treasury. We have developed a software tool that automates this and other important and useful tasks.
The Funding Model provides several benefits:
- It shows actual, budget and forecast data
- It is the basis for generating forecasts
- It is useful to all stakeholders. For management, it shows all the sources of cash, as well as all the movements and outflows of cash
- For providers of finance, it shows the entire cash picture and quickly highlights leakages and potential problem areas
- It provides an extended format for new ratios that focuses on cash and liquidity risk
- It provides the basis of graphic views that show a clearer cash-focused picture in a business
- Understanding cash in its entirety paves the path to improved cash management, lower liquidity risk, and better control of the important parts of the business
Now, let’s highlight some innovative tools relating to the Funding Model.
Users of forecast data require the assurance that projections are as accurate and reliable as is possible. Evidence of accuracy and reliability is usually based on realistic assumptions and expectations, necessary economic variables and business drivers, and valid and understandable calculations.
Cash flow forecasts are required for both internal and external stakeholders. The question is, what forecast techniques are valid for what particular purpose? It depends on the method mandated or preferred by the provider of finance or user of forecast data.
We developed an innovative alternative method to predictive analytics that has been shown to be reliable and to possess the characteristics required by all stakeholders
Predictive analytics uses a variety of forecast techniques and is a term currently in vogue. The problem is that it’s mostly a “black box” to the majority of users because the statistical algorithms are not readily understood.
We developed an innovative alternative method that has been shown to be reliable and to possess the characteristics required by all stakeholders.
Economic and business drivers
We found that cash flow forecasts and modeling based on economic drivers are intuitively logical, easy-to-understand and very useful.
A set of economic drivers is selected and each driver is weighted for its importance. Only the critical economic drivers are included in the algorithm. The selection and weightings are done by each business unit, and differ by country, where different drivers are relevant.
Next is to apply this basket of economic indicators to the various line items in the Funding Model that drive cash flow, such as cash sales and all the different inflows, debtors, non-operational flows and expected capex outflows.
We run this on a monthly basis for the desired period of the forecast, usually from two to 30 years. Once set up, even a 25-year forecast can be created within a few minutes.
What-if modeling can be performed on the forecast figures to help shape an acceptable forecast data set.
Scenarios provide upper and lower boundaries or bands. The scenario terms ‘high road,’ ‘low road’ and ‘expected road’ are familiar to many. Usually the high road is a 5% increase over the expected road, and the low road is a 12% to 15% percent decrease from the expected road.
Scenarios facilitate individual economic drivers to be varied within a context of possibilities. Using scenarios means the element of surprise is limited.
About the Authors
Carosin Buitendag is group treasurer of DAWN Limited in Johannesburg, South Africa. Terence Kades is managing director of enterprise software developer PowerStrat BI. This article is excerpted from Innovations in Cash Flow Forecasting, Liquidity Management on the website of the Association for Financial Professionals.
Copyright © 2016 Association for Financial Professionals, Inc. All rights reserved.